Above the Noise: Elections, inflation, and the US banking system

I’ve been reflecting a lot lately. I’ll chalk it up to the four-year anniversary of the COVID outbreak. It’s comforting for me to contemplate how far we’ve come in such a short time. A weight was lifted when I no longer had to make parenting and investment decisions in the throes of a pandemic.  

My unquiet brain has also been ruminating over the period before the Global Financial Crisis. No, I don’t believe we’re heading towards a leverage-driven calamity. Rather, I’m reminded of the period in the spring and summer of 2007 when oil and copper prices spiked¹, inflation climbed², and the 2-year US Treasury rate surged by over 60 basis points to hit 5%.³ I vividly remember being told by many that the US Federal Reserve was going to have to raise rates again. That hasn’t aged well. Unfortunately, it’s all too familiar to what I’m hearing in certain corners now. I’m not buying it this time either. Policy tightening operates with variable lags. A hard landing for the US economy is unlikely, but a slowdown and coincident easing cycle are likely coming.

As an investor, I prefer to not fight the Fed.

It was said (Part 1)

“We’re waiting to become more confident…when we do get that confidence—and we’re not far from it—it’ll be appropriate to begin to dial back the level of restriction.”⁴ – Jerome Powell

That’s music to my ears. If the core Personal Consumption Expenditures index, which is the Fed’s preferred measure of inflation, has grown by only 2.8% over the past year⁵ then why do we need a Fed Funds Rate of 5.25%?⁶ That feels unnecessarily restrictive, particularly for the nation’s regional banks, which could greatly benefit from the normalization of the yield curve. 

It may be confirmation bias but…

…the evidence suggests that US inflation will cool regardless of the “stickiness” seen in recent reports:

• Wage readings are falling⁷, and consumer inflation expectations have come down sharply.⁸
• Container freight rates have fallen by 20% since the end of January, even as conflict in the Red Sea persists.⁹
• The shelter component of the Consumer Price Index, which tends to lag real-world shelter pricing by a year, is still likely to moderate.
• The S&P CoreLogic Case-Shiller US National Home Price Index was growing at a negative rate last spring.¹⁰   

It’s that time again?

At the risk of being a broken record, there is too much investor focus on the US presidential election. I’ve often joked that when the Levitt family goes to Washington, DC, we don’t first go to the White House but rather to the Federal Reserve Building. That way the family can see where the decisions that truly matter for the financial markets are made.

Historically, presidents have been helped or hurt by whether the Federal Reserve has been working to ease or tighten financial conditions. As an example, Trump and Biden both experienced strong equity returns in their first years in office, only for the second year to be challenging as the Federal Reserve raised interest rates. In each case, third year returns were strong as the Fed backed off their tightening stances.¹¹ By January 2025, the Federal Reserve is likely to be in an easing cycle. History suggests that may benefit the market regardless of who wins the election.

(Read more about why I believe investors shouldn’t worry about the election results.)

Since you asked

Q: Are you concerned that the US equity market won’t perform well in 2025 if the corporate tax cuts of 2018 are allowed to expire?

A: First, it’s hard to be concerned when we don’t know what the outcome of the election will be. Second, let’s not assume that we know exactly what any administration will do. Remember the feared fiscal cliff in 2013? President Obama ultimately extended 82% of the Bush-era tax cuts.¹² Finally, the corporate tax rate has increased five times since 1950.¹³ The US equity market posted gains in each of those five years. The average return was 12.96%.¹⁴ Let’s not stress about this.

Phone a friend

Interest rates have once again moved higher. Are you concerned that this is the result of investors losing their appetite for US debt? I posed this question to Arnab Das, Global Macro Strategist at Invesco. His response:

No, fiscal concerns do not appear to be driving US rates. Historically there has not been a clear relationship between the yield that investors require to hold a longer-term security and the fiscal status of the US. In fact, the additional real yield required to own longer-term bonds has been remarkably stable over time, suggesting that there is not a fiscal credibility problem.¹⁵ For what it is worth, the inflation compensation that investors require has also been stable over time, indicating that the US Federal Reserve also does not have a credibility problem.¹⁶ Rather, the incremental yield demanded by investors to own longer-term security appears to be almost entirely driven by Federal Reserve policy.¹⁷ This suggests that the upcoming Fed easing cycle will likely drive interest rates lower across the yield curve, irrespective of the fiscal health (or lack thereof) of the US government.

On the road again

My recent travels took me to Greenville, South Carolina. I was told by a client that the audience was impressed by the number of charts that I had brought with me. I quipped that I’m paid by the chart. He said, “Maybe you should be. Perhaps you could advise one of the candidates. Provide them charts for the campaign trail, like Ross Perot had in 1992.” He then asked if I could give each campaign one chart then what would it be? Oh boy. Dangerous ground. Here goes:

• I would give the Trump campaign a chart showing US economic growth significantly outpacing that of the rest of the G7 from the start of the pandemic through the subsequent years.¹⁸
• I would help Biden show that the conditions for the inflation that occurred during his term were set in motion by the outsized response to COVID. The chart would show the money supply growth peaking, as he was taking office in early 2021, at 26% year over year (compared to a 6.8% average from 1959-2019).¹⁹ What’s that Milton Friedman said about inflation being always and everywhere a monetary phenomenon?

Did I handle that well? I’m not sure if I pleased everyone or upset everyone. I will not be seeking Invesco approval to have an outside business interest of providing charts to politicians. I doubt this election will be won by the stat keepers anyway.

Welcome to April. Spring is here!